Individuals may have a substantial portion of their net worth concentrated in their company's stock, either through direct common stock holdings or derivatives such as employee stock options. Tax and regulatory restrictions have generally left few economically efficient alternatives for holders of these equity positions to diversify their risk. These restrictions are most onerous for holders of employee stock options seeking to generate additional income and/or manage the risk associated with the issuer/employer's common stock.
Presently, unlike freely tradable shares of stock, employee stock options are generally not transferable and most significantly do not have margin value. Therefore, investors hedging employee stock options by selling listed equity options, such as call options, are required to post other acceptable collateral to meet margin requirements (discussed in further detail below).
In addition, US tax law generally prevents individuals from hedging their employee stock options. Specifically, if the stock underlying an employee stock option appreciates after an individual hedges, employee stock option gains are ordinary in character and corresponding hedging losses are generally capital. Because capital losses cannot offset the tax on ordinary income, the losses are deferred unless the individual has capital gains from other investments.